Wall Street's last standalone investment banks, Morgan Stanley and Goldman Sachs, anxiously tried to reassure staff and clients as their shares collapsed for a second consecutive day, fuelling doubts about their future as independent businesses.

Under increasingly urgent pressure to do a deal, Morgan Stanley pursued advanced merger negotiations with the US commercial banking firm Wachovia and held discussions with China's CIC about a possible capital infusion.

But Wall Street sources said Morgan Stanley had rebuffed an approach from Citigroup for a tie-up. Such a deal would have involved a great deal of overlap, potentially putting many thousands of jobs at risk.

At a hastily arranged "town hall meeting" in New York, Morgan Stanley's chief executive, John Mack, tonight told staff that although he would prefer the firm to remain independent, all options were on the table.

Amid increasing signs of panic among investors, Morgan Stanley's shares were down 28% by lunchtime in New York and Goldman's stock dived by 14%. Since the beginning of the week, Morgan Stanley's market value has halved, losing $17bn in value, while Goldman's has dropped by 35%, dropping by $21bn.

Senior executives at both Morgan Stanley and Goldman Sachs believe the collapse in confidence is nonsensical. They argue that it is driven by short sellers out to make a quick buck. Both banks are profitable and insist that they have nothing like the liabilities held by their erstwhile rivals Bear Stearns and Lehman Brothers.

At Morgan Stanley, insiders said the firm was still prospering, picking up 16 new client mandates in Europe this week of which half were from defunct Lehman Brothers.

"We're dealing with a completely irrational market reaction," said a source at one major bank. "But if you live by the market, you have to accept that markets can occasionally be irrational."

Founded in 1935, Morgan Stanley employs 48,000 people in 33 countries. Its board of directors includes Howard Davies, the former head of the Financial Services Authority.

Morgan Stanley was originally an investment banking breakaway from the commercial banking network JP Morgan. Critics are now questioning whether a Wall Street bank can survive without a high-street network, pushing it into the arms of Wachovia which has 3,300 branches across America.

But there was scepticism among analysts about the logic of a deal with Wachovia, which has had its own problems with sub-prime security liabilities at a homeloans company, Golden West Financial, which it bought two years ago.

Merrill Lynch's banking analyst, Guy Moszkowski, described the combination as a "potential mismatch" which would saddle Morgan Stanley with credit risk: "It is difficult for us to perceive a strategic benefit for Morgan Stanley, which would be merging with the weakest of the five major US banks."

China's CIC is Morgan Stanley's biggest shareholder with a stake of 9.9% and another option pursued by Mack was to sell up to 49% to the state-controlled fund - stopping just short of handing the Chinese government control of a major US bank.

Although Goldman Sachs was under slightly less pressure than Morgan Stanley, sources said it, too, was opening up channels of communication with sovereign wealth funds. Chief executive Lloyd Blankfein offered assurances to staff that Goldman's relatively strong trading performance would see it through.

Experts said that a herd mentality was setting in. In a research note, Citigroup's chief US equity strategist, Tobias Levkovich, wrote: "Fear seems to be overtaking any rational discourse with the credit crunch slipping into crisis proportions and the desire to be in cash overwhelming any willingness to remain invested in equities."

The index of market volatility, known as VIX, reached its highest level since 2002. Levkovich said that after a 25% fall from their peak, stocks are down by more than the average slump for an entire recession.

Several US money market funds, usually seen as ultra-safe, shut down after struggling with Lehman Brothers debt which had been viewed as low risk until this week.

An auction began for the troubled Seattle-based bank Washington Mutual, which has 2,200 branches across the US. It has called in Goldman Sachs to find a buyer. There has been speculation that Britain's HSBC could be interested. Others mentioned include JP Morgan, Bank of America and Wells Fargo.